The London Interbank Offered Rate (LIBOR), the most widely used benchmark rate, is scheduled to go away by the end of 2021. Therefore, we are in an era of transition as many industries switch to an alternative rate. In the US, the Alternative Reference Rates Committee (ARRC) has recommended Secured Overnight Forward Rate (SOFR) as the alternative replacement rate. This will impact every entity that has a contract/instrument that refers to LIBOR or any other interbank offered rate that is expected to be discontinued. LIBOR is commonly seen in agreements for debt, investments, derivatives and may also be present in leases, compensation agreements or intercompany agreements.
To ease and streamline the challenges faced in financial reporting, the Financial Accounting Standards Board (FASB) has issued ASU 2020-04, Reference Rate Reform (Topic 848), directly addressing the accounting impact. This guidance was effective immediately upon issuance on March 12, 2020. However, the optional expedients and relief under the guidance is only temporary and can be applied through December 31, 2022.
Topic 848 simpliﬁes the accounting analysis for contract modiﬁcations aﬀected by reference rate reform, including rates referenced in fallback provisions. It also simpliﬁes the accounting for contemporaneous modiﬁcations of other contract terms related to the replacement of reference rate, including contract modiﬁcations to fallback provisions. It does this by permitting the following optional expedients:
- Receivables and debt: Modiﬁcations within the scope of Topic 310, Receivables, and Topic 470, Debt, should be accounted for by prospectively adjusting the eﬀective interest
- Leases: Modiﬁcations within the scope of Topic 842, Leases, should be accounted for as a continuation of the existing contract with no reassessments or remeasurements of lease classiﬁcation, discount rates, or lease payments.
- Derivatives and hedging: Modiﬁcations within the scope of Topic 815-15, Derivatives and Hedging—Embedded Derivatives, will not require a reassessment of whether an embedded derivative should be accounted for as a separate
The relief is limited to changes being made to the terms of the contract that include a direct replacement of a reference rate being discontinued or other modiﬁcations to terms that are considered related to the replacement of a reference rate. The optional expedients and accounting relief do not apply to modiﬁcations that occur in the ordinary course of business or for reasons unrelated to reference rate reform, such as borrowing base re-determinations, extensions, and covenant remedies.
If a contract modiﬁcation includes both a reference rate change and other substantive changes that are unrelated to reference rate reform, the contract does not qualify for the practical expedients or accounting relief.
Further updates in ASU 2021-01 expand the scope of Topic 848 to include all affected derivative instruments and provide the ability to apply certain aspects of contract modification and hedge accounting expedients to derivative contracts affected by discounting transaction, and add implementation guidance as to which optional expedients can be applied to these derivative instruments.
- Real estate companies may have dozens or hundreds of loan agreements referencing LIBOR, in addition to countless swaps and caps. Has your organization begun the process of evaluating the financial instruments and contracts that are affected by the reference rate reform? Make a list of these contracts and agreements. Research each and come up with a plan to include a replacement rate for LIBOR or to include fallback language to be added to these agreements.
- This transition period will not only lead to new rates, the impact of which will take time to understand, it is also an evolving situation. AARC has established the user’s guide to SOFR which talks about the options available, like SOFR in arrears, in advance, or even the possibility of a term rate. Test out the waters in the SOFR world by borrowing money or invest in a bond indexed to SOFR.
- Another important thing to think about is any accounting exposure, including situations where there is any reference to LIBOR. For example, companies may have previously employed LIBOR in arriving at the discount rate for real estate valuations, including purchase price allocations and impairment analyses.
This is a period of uncertainty and the process is time consuming and cumbersome, but there is no avoiding it. The sooner everyone embraces the change, the better.